Sell-Off Finally Staunches Municipal Fund Inflows

The sell-off in municipals last week finally stemmed the tide of cash that had flooded municipal bond mutual funds for the better part of a year. Investors entrusted $615 million to municipal funds during the week ended Oct. 14, according to Lipper FMI. That is the puniest slug of money poured into muni funds since April.

Funds have reported an average of $2.62 billion in inflows a week over the last four weeks, which is still extraordinarily high. But the latest inflow, coupled with the bond market's recent drubbing of municipals, may signal a shift.

Funds reported market losses of $4.83 billion last week, the first weekly loss since July. For the first time since June, the municipal mutual fund industry's assets fell last week, to $454.91 billion from $459.1 billion.

Ron Schwartz, who manages two tax-exempt mutual funds with $1.07 billion in assets for RidgeWorth Investments, said his funds have been collecting more realistic sums from investors after a bonanza in August and September. It is probably for the best, according to Schwartz. The rate at which yields were plummeting and investors were bestowing money to mutual funds was not sustainable, he said.

The municipal market had rallied mightily for months, bolstered by a distortion in the supply-demand equilibrium. On the supply side of the equation, municipalities have sold $41.83 billion in Build America Bonds this year, siphoning at least some supply out of the tax-exempt muni market and into the taxable bond market.

About 17% of municipal issuance this year has been in the taxable market, according to Thomson Reuters. That translates into less supply for traditional tax-exempt investors.

Meanwhile, retail investors have been heaping cash into municipal mutual funds at an average rate of $1.6 billion a week in 2009. Tax-exempt mutual funds have reported $65.78 billion of inflows this year, easily a record.

Because tax-exempt funds do not have much choice but to invest in tax-exempt paper, those inflows fueled demand that McDonnell Investment Management Director of Research Richard Ciccarone calls "captive" - meaning they have to buy tax-exempt paper whether they like the price or not.

The yield on the 10-year triple-A muni, based on the Municipal Market Data scale, dropped 65 basis points from the beginning of July through the end of September. The yield touched its lowest level since MMD started keeping track in the early 1980s.

Many municipal mutual funds last month hit their highest net-asset values in at least a year. Earlier this month, the rally stalled. The MMD scale's 10-year triple-A muni swelled almost 50 basis points.

George Friedlander, muni strategist at Morgan Stanley Smith Barney, in a report dated Oct. 9 blamed heavier issuance of new bonds, resistance to such low yields, and concerns that dealers would not be willing to take on much inventory as they wind down the year in the black.

The biggest municipal exchange-traded fund, the iShares Standard & Poor's National Municipal Fund, is down 2.7% this month.

Cecilia Gondor, executive vice president of Thomas J. Herzfeld Advisors, said the discounts on municipal closed-end funds have been widening, which means demand has waned. "We went so far and so much and so quickly, so we're basically corrected here, which was necessary," Schwartz said. "It's all putting things back into a normal cycle rather than what we were witnessing."

The net assets of many of the biggest funds have retreated from recent peaks. The biggest muni fund, the Vanguard Intermediate-Term Tax-Exempt Fund, with $26.2 billion in assets, has net asset value per "admiral" class share of $13.41, down from $13.73 at the beginning of the month. The Franklin California Tax-Free Income Fund, the second-biggest fund at $14.66 billion in assets, has slipped to $7.04 per share net assets from $7.19 at the beginning of the month.